3 From the last session Current Account Deficit = Net Capital Inflows or Declining Central Bank Reserves With capital inflows, current account deficits can be sustained for long periods. Without the inflows, there must be depreciation, which will correct the CA deficit. Loanable Funds Market Equilibrium: S p + S g I = CA or S p + S g + KA = I KA can be seen as foreign savings, which can finance Investment or Consumption. A net use of foreign savings (KA>0) involve a deficit in the current account (CA<0) The current situation of large current account surpluses in developing countries (e.g. China) and deficits in rich countries (e.g. USA) is unstable, because it implies that Capital is flowing from poor (KA<0) to rich countries (KA>0). A reversal of these unstable capital flows will lead to a large dollar depreciation. 3

5 Varying degrees of Capital Mobility (II) The practical reality is that all economies are somewhere in between Several countries impose restriction on inflows and/or outflows of capital (e.g. China), based on maturities, strategic concerns, etc. However, capital often is able to elude controls. Some countries allow only long-tem capital flows (e.g. FDI), but not speculative flows Most investors have a domestic bias, i.e. they have a preference for assets of their own country, although they tend to react to changes in return differentials. Some countries are large and have an effect on the global benchmark but focusing on extreme cases makes theory easier to convey. 5

12 The Mexican Crisis: Background After the debt crisis Mexico was isolated from the world capital markets until the end of the decade. By 1987, investors return to developing countries and Mexican risk falls, creating a large inflow of foreign capital. In Mexico received $91 billion of net capital flows (about 20% of the total capital flows to developing countries). $61 billion took the form of portfolio investment. 12

13 The 1991 Peg Between 1987 and 1991, the Peso maintains a steady value against the dollar (flexible, but managed, exchange-rate). By 1991, the central bank s decides to officially maintain a fixed exchange-rate with the US$ USD / Peso

14 The Interest Rate The Nominal Interest Rate in Mexico Lower risk induces capital inflows, which lowered the real interest rate Interest Rate Inflation Nominal interest rates fall, also due to decline in inflation The government pursued an antiinflationary policy, but inflation remained above US levels

16 The Real Exchange Rate Exchange Rate (USD/Peso) Very stable peg. Real appreciation of the PESO: Mexican inflation > US inflation Nominal Real With lower interest rates, the economy boomed and inflationary pressure rose. The economy is increasingly dependent on capital inflows to sustain the current account. Two factors contribute the current account deficit With the nominal ER pegged, inflation led to an appreciation of the real exchange rate Rising income increased demand for imports, including for rising investment Is the current account deficit a concern? What are the dangers? Was the exchange rate overvalued? 16

17 Two views of the Trade Deficit View 1: Sustainable, no overvaluation of RER The trade deficit is the result of higher investment in Mexico. Growth of productive capacity will pay a return to capital inflows (provided investors are willing to wait). Now: Y= C + I + G + NX Future: Y = C + I + G + NX Food and Beverage Industrial Supplies Composition of Mexican Imports all figures expressed as percentage of total imports View 2: Unsustainable, overvalued RER Fuels The trade deficit is unsustainable and the result of an overvalued real exchange rate. The foreign flows are being used for consumption. Growth will not be sufficient to create export capacity to pay them back. Machinery Transport Consumer Goods Now: Y= C + I + G + NX Future: Y = C + I + G + NX Total

18 The Mexican Crisis: panic Events in 1994, lead to interest rate pressures Peasant uprising in Chiapas and Assassination of leading presidential candidate raise Mexico s risk premium The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. How do capital flows affect the Central Bank? What are the implications for Monetary policy? Questions for the next session!... 18

19 Summary The long-run real interest rate The loanable funds market interprets the interest rate as the balance of Savings and Investment With Capital Mobility, the interest rate is determined by international benchmarks, given the availability of foreign savings (capital inflows). In this case, current account deficits can be sustained for long periods. Budget deficit imply lower government savings which imply more private savings and/or lower investment (through a higher interest rate) and/or more foreign savings (through a current account deficit) The Mexican crisis Current account deficits can be sustainable, if the country expects economic growth that generates returns to repay foreign capital. Foreign capital can help this economic growth (financing expanded investment). Otherwise, deficits may be unsustainable and lead to painful adjustments, when foreign capital realizes that there will be no returns (default on debt; low stock market returns). 19

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